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Emerging markets bonds:

Cause for concern?

Investors have become increasingly worried about bonds issued by emerging market companies. Emerging markets include countries like India and Brazil, which are at an earlier stage of political and economic development than developed markets such as the UK and US. As such, they can present greater risks, but are often growing at a faster pace, thereby offering some good potential investment opportunities.

Several near-term factors have been concerning investors in emerging markets recently, including a slowdown in the rate of growth of the Chinese economy, which is hitting demand for exports from other countries and leading to a steep decline in commodity prices. Commodity-exporting emerging-market countries, such as Venezuela, Brazil and Russia have been hit particularly hard.

Bonds issued by companies in emerging markets can offer very attractive yields, particularly when compared to those issued by companies in developed markets. But they are also subject to additional risks. Emerging markets generally have greater political and socioeconomic instability. Furthermore, there is the risk that the local currency in which emerging market bonds are issued could depreciate against the investor’s home currency, thereby lowering overall returns.

Most emerging market debt is issued in US dollars. While this protects investors against depreciation of the local currency, it makes it more difficult for the issuing countries to repay if their currency depreciates against the dollar. This is why an increase in the US interest rate is viewed as negative for emerging markets. As interest rates rise, funds will tend to flow back towards traditional asset classes such as US treasuries as the yield would have increased along with the interest rate rise, and investors will have less need to take on the extra risk associated with emerging market debt.

Despite these risks, there are some good reasons for investors to consider including emerging market bonds in their portfolios.

So what are some of the concerns that investors have about the asset class, and what are the counter-arguments?

  1. Defaults – “Emerging market bonds are risky and there are many defaults”
    Some investors perceive emerging market bonds as being riskier than those issued by US companies that have been rated as “sub-investment grade”. The latter type of bond is also known as “high yield” or “junk”.

    In reality, emerging market companies have a better record of meeting their debt obligations. Research undertaken by Aberdeen Asset Management shows that the proportion of US companies defaulting (failing to meet their debt repayment obligations) on high-yield bonds is expected to be around 6% this year. For emerging-market companies this figure is barely 1.5%. Over the past 15 years, the same analysis suggests that emerging-market bond defaults have consistently been below default rates for US high-yield bonds.

    Also, some investors think of emerging market companies as being small, niche organisations. But there are many big emerging market players, including Hutchison Whampoa, the biggest port and telecoms company in the world; ICICI, the largest private sector bank in India; and MTN, the biggest telecoms company in Africa. So this perception is often misplaced.
  2. Too much – “The amount of debt issued is a hazard in itself”
    The value of bonds issued by emerging-markets companies has risen in recent years, but this should be put into context. In Asia, the amount of corporate debt has gone from 2% to 4% of the overall economy of the region, as measured by gross domestic product. In Latin America, the percentage has risen from 4% to 9% and in the Middle East and Africa, from 4% to 7%.These are very manageable numbers, so even if demand for these bonds from foreign investors were to fall, the effect on prices should not be too significant.
  3. Net borrowing – “Supply exceeds demand”
    Supply and demand drives any well-functioning market. New bond issuance (i.e. supply) was about US$240bn over the twelve months to 31 December 2015, and that was 35% lower than the amount issued during the previous year. Money paid back to investors was close to US$200bn last year, meaning that the net value of new bonds being issued to the market was only about US$40bn.

In the US and Europe some high-profile companies have been returning cash to shareholders by buying back shares. However, emerging market companies have been using their excess cash differently and have been buying back bonds instead. In 2015 there was a record amount of bond buybacks in emerging markets, totalling almost $40bn. In other words, they have been reducing their debt burdens.

If this $40bn is set against the net value of new bonds issued i.e. $40bn, then net borrowing undertaken by emerging market companies is close to zero. And that figure could even turn negative in 2016 if issuance this year remains low. If demand then starts to exceed supply, this would be positive for the prices of bonds which would support the case to invest in them.

Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at May 2016. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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